Bernanke to Outline Fed Exit Strategy in Testimony

Federal Reserve Chairman Ben Bernanke is expected on Wednesday to outline the U.S. central bank's strategy for tightening monetary policy once it is confident in the strength of the economic recovery.

The Fed chairman's prepared testimony will be released at 10 a.m. EST, even though the congressional hearing where he was due to testify has been postponed.

The Fed cut interest rates to near zero in December 2008 and further eased financial conditions by putting in place an array of liquidity and long-term asset purchase programs.

Much is at stake in how and when the Fed decides to wean the economy and markets off its extraordinary support, and the timing and the sequencing of the steps is subject to much market speculation.

Central to the Fed's strategy will be its ability to pay interest on the excess reserves it amassed during the crisis as its balance sheet grew by more than $1 trillion.

The interest rate the Fed pays on excess reserves will be the one to watch once the Fed begins to tighten policy.

Below are the exit strategy tools the Fed has said it could use when the time comes to tighten monetary policy.

By raising the interest rate it pays on bank reserves, the Fed essentially creates a magnet for banks to keep those reserves with the Fed rather than lend them out into the financial system.

"Banks will be unwilling to make overnight loans to each other at a rate lower than the rate that they can earn risk-free from the Fed, and so the interest rate we pay on banks' balances will tend to set a floor below our target overnight loan rate and other short-term interest rates. Banks generally will not lend funds in the money market at a rate lower than they can earn risk-free at the Fed," Fed Chairman Ben Bernanke said in a Dec. 7 speech.

A number of central banks around the world have effectively used similar tools.

They would temporarily drain reserves from the banking system and reduce excess liquidity at other institutions.

Reverse repos involve the sale by the Fed of securities from its portfolio with an agreement to buy them back at a slightly higher price at a later date.

The Fed has said it could conduct reverse repos with a number of institutions, not just primary dealers, its usual counterparties.

The Fed has proposed creating a new "term deposit facility" for banks, similar to certificates of deposit that banks offer retail customers.

Like the reverse repos, this would reduce the supply of funds banks have available to lend to each other.

Bernanke said on Dec. 7 that this would put "additional upward pressure on short-term interest rates.

"By paying a slightly higher rate of interest, we could induce banks to lock up their balances in longer-term accounts with us, making those balances unavailable for lending in the overnight market," he said.

In its proposal, the Fed envisioned having the interest rate set by auction but subject to a Fed-set cap, although it said it could also set the interest rate administratively.

While the Fed already pays interest on reserves held overnight, a term deposit facility would lock up funds for a longer period of time.

In its proposed rule making, the Fed said deposits would not exceed one year and would likely have maturities ranging between one and six months.

The Fed could sell a portion of its securities holdings into the open market.

"If necessary, we always have the option of reducing the size of our balance sheet by selling some of our securities holdings on the open market," Bernanke said on Dec. 7.

St. Louis Federal Reserve Bank President James Bullard told Reuters on Dec. 8 the central bank could begin to sell off some assets as soon as the second half of this year to test the market response if the economic recovery was better established.

Federal Reserve Chairman Ben Bernanke is expected on Wednesday to outline the U.S. central bank's strategy for tightening monetary policy once it is confident in the strength of the economic recovery.
The Fed chairman's prepared testimony will be released at 10 a.m. EST,...